Will the Fed Allow a Market Crash, or Submit to Decades of Stagflation?

Using Japan’s last 20 years as a model, analyst Nilus Mattive digs into the Federal Reserve’s current dilemma, which might involve a choice between conceding a stock market crash and suffering through many years of stagflation.

As you almost certainly know, Janet Yellen and six other voting members of the Federal Reserve outweighed three dissenters and opted to keep the current Fed Funds target in place yet again in September.

Maybe this surprised you at the time. Me? Not so much.

There was a time — perhaps a year or two ago — when I still had a little tiny bit of hope that the Federal Reserve would try to stay ahead of things by unwinding its aggressive monetary easing.

But now it’s almost like a bad joke: Maybe in June. Maybe in September. No, really. Maybe in December now. (Note that market action currently places the odds not much more than 50-50.)

What I find interesting is that Yellen said the Fed’s decision “does not reflect a lack of confidence in the economy” while also noting that the Fed was lowering its GDP growth estimates based on slower-than-expected gains in the first half of the year.

So they have confidence in the U.S. economy but are lowering their growth forecasts?

Moreover, she said FOMC members believe “risks to the outlook have become roughly balanced” and that a gradual increase in rates is the right course of action to avoid sparking a serious bout of inflation.

I have to laugh when I hear the word “gradual.” Take a look at this chart, which shows the effective Fed Funds rate since 1980 …

As you can see, it took the Fed nine years to move rates one inch off the bottom. Even if a December hike DOES happen, that would put us on a pace of one tiny bump at the end of every year.

Hey, maybe we’ll hit a Fed Funds target of 1% by 2018!

Truth be told, it feels like we are now actually entering the worst-case scenario: an extremely protracted bout of economic limbo, with little room for error.

We should certainly appreciate the irony that, on the same day Yellen was delivering her “no hike” speech, Japanese central bankers were trying yet again to spark economic growth in a country that has been using various forms of extreme monetary easing for two decades now.

The Bank of Japan’s latest idea is trying to push yields on 10-year government bonds to zero.

So, yeah, loan your money to the government for a decade and earn no interest in the process. What a deal!

Of course, most other bonds issued by the Japanese government already have negative yields.

It’s no secret that the Bank of Japan first started using “quantitative easing” methods to try and combat deflation as early as 2001. Or that everyone from the Federal Reserve to the European Central Bank has also undertaken their own versions of these policies since the financial crisis hit in 2007 and 2008.

But clearly, Japan is still stuck in the same place — unable to spark longer-lasting domestic growth or any type of inflationary uptrend.

Could that same thing be happening here in the U.S. as well as other developed economies in the West?

That’s what keeps me thinking these days.

After all, we have already had at least one voting Federal Reserve member forecast a negative Fed Funds interest-rate target.

Then, more shockingly, last Friday we heard Larry Summers suggest the idea of government purchases of publicly-traded stock as a way to reignite growth in a world where monetary policymakers “are fairly near the end of the rope.”

Oh, and where did that happen? At a Bank of Japan conference in Tokyo!

More irony.

I know, I know. Summers later told reporters, he’s “not prepared to make a policy recommendation at this point.”

Still, Summers is a top economic adviser to President Obama. He is a former head of the U.S. Treasury. He is the president emeritus of Harvard. And I am sure he is not the only high-ranking policy person in Washington thinking about this kind of stuff.

It’s scary to imagine a world where you would end up PAYING to loan money to the government and, at the very same time, the government would be investing that money into private companies.

Talk about a perversion of the markets.

Of course, what’s the other scenario? Simply reverting to more conventional policies and letting global assets possibly revert to the prices that actually make sense based on fundamental forces?

You can see why we may truly be going the way of Japan … with another 10 or 20 years of low interest rates and economic stagnation still ahead of us.

So when I come back down to a practical level, I continue to believe the best course of action for regular investors is remaining relatively conservative — by maintaining healthy levels of cash and holding quality income-producing investments for the long haul.

The SPDR Dow Jones Industrial Average ETF (NYSE:DIA) was unchanged in premarket trading Tuesday. Year-to-date, the only ETF that tracks the DJIA has risen 4.79%.